Prices rise, curve flattens on rate hike speculation

U.S. Treasurys rose on Friday and the gap between short and long-dated bonds hit its lowest level in eight months as investors continued to evaluate the possibility the Federal Reserve will increase benchmark rates sooner than had been expected.

The yield curve has flattened since Wednesday, when Fed Chair Janet Yellen said the central bank could raise rates six months after its current bond-buying program ends. The spread between two-year note- and 30-year bond yields narrowed to 317 basis points on Friday, the tightest since July.

"We've seen a continuation of the flattening trend that began post Fed meeting on Wednesday, the timeline for potential tightening is moving up," said Dan Mulholland, managing director in Treasuries trading at BNY Mellon in New York.

The curve flattening was amplified by investors exiting a popular steepening trade that was meant to benefit from longer-dated notes underperforming shorter-dated ones, he added.

Thirty-year bonds extended price gains and the yield curve flattened further after St Louis Fed President James Bullard said Yellen's six-month comment was in line with private sector surveys.

Bullard was one of a quartet of Fed officials that were watched on Friday for further signs over Fed policy after Wednesday's surprise remarks.

Intermediate Treasurys yields held just under two-month highs with the Treasury poised to sell $96 billion in new coupon-bearing supply next week, including two-year and five-year notes, which have been the worst performers since Yellen's comments.

Two-year note yields have risen to around 44 basis points from 34 basis points before Yellen's statement. "If they are looking to raise rates in spring 2015 two year notes at 44 bps still look pretty rich," said Jason Rogan, managing director in Treasuries trading at Guggenheim Partners in York.

Five-year note yields, which are the most sensitive to Fed policy, have increased to 1.72 percent from 1.54 percent before Yellen spoke.

The Treasury will sell $32 billion in two-year notes on Tuesday, $35 billion in five-year notes on Wednesday and $29 billion in seven-year notes on Thursday, in addition to $13 billion in reopened two-year floating rate notes on Wednesday.

Of the Fed speakers on Friday, Minneapolis Fed President Narayana Kocherlakota, told the Wall Street Journal the Fed was not moving to a more hawkish stance.

The lone dissenter to the Fed's policy decision this week said in prepared remarks early on Friday that the U.S. central bank should have promised to keep rates near zero until U.S. unemployment falls below 5.5 percent, as long as inflation and financial stability risks are contained.

Dallas Fed chief Richard Fisher, a frequent critic of the U.S. central bank's super-easy monetary policy, questioned the basis of forward guidance, which rests on giving markets a better sense of the future path of interest rates.

Bullard also said that using monetary policy to target a specific rate of economic growth poses challenges including the difficulty of knowing how fast the economy really should be growing. Kocherlakota is due to speak again later on Friday as is Fed Governor Jeremy Stein.

The Fed bought $1.23 billion in bonds due from 2036 to 2044 on Friday as part of its ongoing purchases. It will buy between $2.25 billion and $2.75 billion in notes due 2021 and 2024 on Monday.